Not wanting Bad Investments does not equal Socialism

“He’s saying that in a low interest rate environment we dare not leave investment decisions up to the private sector, which is going to just blow the money on boondoggles and white elephants—the state needs to step in and plan the economy. Socialism, in other words. But does Summers really think that? It sure doesn’t sound like something he thinks.”

Here is the problem paragraph by Summers:

“However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.”

I don’t see much of a problem here. This is an entirely reasonable statement.

It’s worth stating clearly: negative interest rates involve paying the borrower to borrow money. In a negative interest rate environment, the lender is paying money to the borrower so they will borrow money.

Usually, people and companies have to pay to borrow money. You go to the bank, get a loan, and pay the entire amount of the loan back, with extra money in addition to the money you borrowed.

This extra money is a way to compensate the lender for the risk of possible default, non-payment, or delayed payments. Negative interest rates turn this relationship on its head, so that the borrower is being paid for the trouble of actually borrowing money.

You can think of negative interest rates as borrowing money, and then paying back less than you borrowed, keeping some of the money you borrowed as your own.

What types of investments have such poor future returns someone would have to pay you to make the investment? Well, risky investments with poor certainty of returns. Or possibly, investments which don’t entirely cover lending costs.

The first – poor certainty of returns – seems like a bad investment anyway, and probably not ones we should choose for our economy.

The second reason – investments which do not cover lending costs – is the definition of ponzi finance for Minsky. Ponzi finance is where the investment does not generate enough cash flows to cover lending costs, so the investment asset must go up in value to create a profitable investment opportunity. It’s the final stage before a credit bubble breaks and causes disaster.

It’s entirely reasonable for anyone – even a jackass like Larry Summers – to question what types of investments are so terrible someone needs to shove cash money into your hands so you will do the investment. It’s also reasonable to think forcing companies to take loans could lead to another bubble.

There is a case to be made that we should be giving private businesses and people money to promote investment. I’ve made this argument before. And, paying people to take out loans is a way to give people money, so let’s force them to take out loans, right?

However, if we have a choice between giving people money in the form of loans, or simply giving people cash money, I strongly prefer cash money. We do have this choice, so we should probably prefer just giving people money over incenting them to take out loans.

However, today we see something very different. As Exhibit 2 shows, today’s opportunity set is characterized by almost everything being expensive. As I noted in “The 13th Labour of Hercules,”2 this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world.

“The Fed has been unusually transparent in explaining its thoughts on the impact of quantitative easing. Brian Sack of the New York Fed wrote in December of 2009 (bold emphasis added):

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

Market participants have (at least until the last month) reacted to this situation by “reaching for yield” as witnessed by the more detailed fixed income forecasts in Exhibit 3. This could be described as a “near rational” bubble (inasmuch as investors are reacting to the very low cash returns, which they expect to last for a long time). I’ve described it as a “foie gras” bubble as investors are being force-fed higher risk assets at low prices.

A “foie gras” bubble! That’s a good one. I wish I had thought of it.

Still, he gets close to a problem of high asset prices. His concern in the paper is about investing – it’s hard to make money in a market where the expected future returns are very low. The problem with low expected future returns is this means there is a higher possibility of losses in the asset class, and those losses are potentially larger.

We are concerned with something other than returns – we are concerned with the stability of our economy.

You may have heard the phrase “priced for perfection”. In the investing world, this means the asset price is using the best possible scenario as the base case, and any possible negative scenarios are ignored.

I’d argue this is exactly what a reliance on excessive QE does for the market, and what paying people to take out loans does to investments. It forces them to be priced for perfection, where banks are making loans on projects which only make sense if everything works out perfectly.

Banks are smart to be unwilling to loan to projects which are close to being priced for perfection. It’s a reasonable and market driven response to the current situation. High asset prices (and the related low future returns) increase the risk of default and non-payment of loans, and banks are smart to be unwilling to make loans for these projects.

The issues of the FIH (Summers problem #2) and the balance sheet recession (Monitor problem) are related but different problems. The FIH issue relates to causing a bubble, covering cash flows for investments, and the aftermath of the bubble. The balance sheet recession problem relates to the reasonable unwillingness of banks to lend when asset prices are very high.

I think Yglesias whiffed on this one. I am not a huge Larry Summers fan for lots of reasons, but his column from 2012 is actually pretty good.

Michael, agreed, and the Summers vs Yellen debate is frustrating the hell out of me. He has shown himself to be a complete and utter dumbass whose main skill appears to be failing upward. However, he’s absolutely right about fiscal vs QE, imo.

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Greg

3 years 4 months ago

Hey Arturo dont sell the man short!!
How many guys do you know that can fail upwards as well as Larry? It might take more skill than you know.

Sure wish I could

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Arturo

3 years 4 months ago

🙂

How about a ‘failing upward’ pact? If one of us figures out his secret, we hereby agree to share.

In fairness, while Larry deserves a sh*t ton of criticism imo, his paper on Gibson’s Paradox was pretty slick. Maybe Barsky did all of the work…? http://www.gata.org/files/gibson.pdf

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Philip Diehl

3 years 4 months ago

I can assure you Larry is not dumb. He’s one of the smartest people I’ve ever worked with, and I worked with him a lot. He is also one of the most arrogant and tone deaf people I’ve ever met, and he must have an EQ below 100.

I’m not a fan but he rose in my estimation when I heard he was a strong advocate for prosecuting the worst of the banksters. Obama went with Giethner who didn’t want to “destabilize” the economy.

Larry’s re-appt to Tsy apparently was waylaid by Hillary Clinton accepting State. Obama didn’t like the optics of having another Clinton retread in his cabinet. The astonishing thing is that when forced to pick a Tsy Sec from between Paul Volcker (who very much wanted the job) and Tim Geithner, Obama decided Geithner was the man for the job.

The closest analogy I can think of to as to how terrible a decision this was (whether on the metric of experience, public reputation or basic competence) would be if, tomorrow, Bill Belichick announced he was benching Tom Brady and naming Tim Tebow as New England’s starting QB.

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Philip Diehl

3 years 4 months ago

Ha! Both an apt and a disturbing analogy. I think Geithner probably had the job on his first meeting/interview with Obama. They’re very simpatico. Volker is old school and hot. Geithner is O’s age and cool. But no matter who was Tres Sec, O never would have rocked the Wall Street boat in 2009.

Clinton brought Bentsen in as his eminence grise and then used him as a Senate lobbyist. Obama didn’t feel the need for one at all.

I would have had Simon Johnson and Krugman on the short list along with Volker. Geithner did not fit the Team of Rivals O professed to be his model. In fact, who on the cabinet fits that model?

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Arturo

3 years 4 months ago

“I heard he was a strong advocate for prosecuting the worst of the banksters. Obama went with Giethner who didn’t want to “destabilize” the economy.”

Hadn’t heard that, thanks. Worth a few points.

And I believe he’s intelligent, but in total, his political judgment has proven to be much worse than lousy. Might have to do with the emotional intelligence thing.

Finally, in my oversimplifed view of the world, he’s a poster child for the worldwide scourge that is Rubinomics. Too harsh?

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Philip Diehl

3 years 4 months ago

Probably not. I think his participation in the suppression of Brooksley Born’s dissent as describe in 13 Bankers was close to reprehensible. But unlike Rubin, Geithner and Greenspan who have retired into their cones of silence or become defenders of the status quo, I think Larry may have learned a few things from the 1990s.

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beowulf

3 years 4 months ago

Or if it were a movie tagline— sometimes the bad guy is the only guy you can trust.

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Detroit Dan

3 years 4 months ago

Excellent post by Mike, and Arturo’s pithy summary is the quote of the day in my book….

A problem: Summers believes winning an argument is more important than getting a good outcome. He’s used to being correct, which is a dangerous. He’s one of those people who think an argument is won by being louder, and then if not louder, then pure logic. He doesn’t see anything but the winning and losing as being important. So this means he will seize on minor parts of your argument, blow them out of proportion, then claim victory when he demolishes these unimportant parts. It’s the old “Assume your strongest points are wrong. Then, these weaker points are clearly wrong, so you are wrong.”

People who are not used to debating get run over by people like this, and this tactic then tends to totally stifle about 60% of the population. We end up being ruled by loudmouths like Larry Summers.